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Archive for January, 2012

Now you’ve found the right investments, it’s time to consider the right investment vehicle. There are four possible investment structures, each with its pros and cons, especially when it comes to taxation:

■ buy the investments in your own name, in your partner’s name, or both;

■ invest via a self-managed superannuation fund;

■ use a company structure; or

■ set up a family trust.

Generally, it pays to invest in the name of the person with the lowest rate of personal income tax, but capital gains tax considerations can also come into play.

Minimisation good, evasion bad

Tax minimisation – as opposed to tax evasion – is a perfectly legitimate goal when structuring your financial affairs. Income splitting, timing investment transactions and negative gearing are just some of the ways you can limit the eroding effects of tax.

However, tax law is complex and ever changing, so it’s an area where specialist, individual advice is crucial.

And you should never let tax considerations overwhelm your investment decisions. A bad investment is still a bad investment even if, on the face of it, it’s a tax-effective one. There’s no glory in saving tax when you’re losing money on the investment itself.

Income splitting

While some forms of income splitting are prohibited, when it comes to investments households can make decisions about whose name assets should be held in to achieve the best tax result.

Assets could be held jointly, so each party’s tax-free threshold comes into play when the income from those assets is taxed. Or the assets could be in the name of the person on the lower personal income tax rate.

Capital gains tax

A capital gain or capital loss is the difference between the proceeds when you sell an asset and its original purchase price.

Capital gains tax applies to assets bought since September 19, 1985 (when the tax was introduced). It’s applied at your marginal tax rate – in other words, the top tax bracket into which you fall.

But there are two ways you can minimise the amount of CGT you pay. First, hold an asset for more than 12 months and you’ll pay CGT on only half the capital gain. Second, because the tax is applied to your net capital gains you can time asset sales so your capital losses partly or wholly offset your capital gains.

Negative gearing

Negative gearing occurs when the interest you pay on your borrowing for an investment – usually property – is greater than the income from that investment. On the face of it, that’s not a great result. But you can use this shortfall to reduce your taxable income and therefore the amount of tax you pay.

Again, don’t let the tax benefit blind you to all other considerations. You may get a tax break but you still have to be able to meet interest payments on your investment loan.

Apart from the tax break, people negatively gear because they’re more interested in the potential capital gain on a property than the rental income in the meantime. But another risk is that the value of the property will fall.

Superannuation

Of course, another effective way of accumulating wealth is super, which qualifies for attractive tax breaks.

Investment earnings in super funds are taxed at the concessional rate of 15 per cent. That’s likely to be much less than the marginal tax rate you’re paying on other investment earnings – up to 47 per cent if you’re in the top tax bracket.

And there are ways to maximise your super savings.

On the down side, super is heavily regulated, the rules tend to change, and your money is tied up until retirement age. Younger investors may want to keep some of their money in more liquid assets that are more easily accessed.

Looking at a company’s annual reports will tell you a lot about the business. Essentially, what you want is a business with little or no debt that is generating high returns on equity. Keep that in mind as we take a tour through the three statements that form the core of a company’s financial reporting.

The balance sheet

Rule No.1 in investing is: don’t lose your capital. The balance sheet is where you can start to get a feel for whether a company is destined for failure. When things turn sour a heavily indebted company can quickly find that it’s unable to meet its obligations.

A common way to measure the “gearing” of a business is by dividing total debt (say, net of cash) by the total value of the assets (or sometimes the equity) on the balance sheet.

How much debt a company can manage depends on how reliable its earnings are, but for your standard, industrial-type company a ratio of less than 50 per cent debt to total assets is a good starting point.

You can also judge a company’s ability to meet its obligations by turning to the income statement to measure its “interest cover”, which is operating earnings before interest and tax divided by the total interest payments. A cover of four times is solid.

Rising debt could mean the company can’t generate enough cash to fund itself – not a good sign. Similarly, falling debt could mean the opposite.

Income statement

This is where you’ll find the company’s profit. However, be aware that tax rates, writeoffs, acquisitions, one-off sales and cost-cutting can serve to obscure the true, underlying performance of the business.

This is why many analysts prefer to look at the statement of cash flow, which is harder to manipulate.

Nevertheless, tracking the trajectory of operating revenue – “top-line” growth – will give you a good feel as to whether the business is expanding.

Of course, the company could just be raising more and more shareholder equity to fund that growth, which is bad news from an investor’s point of view.

That makes return on equity (ROE) a crucial figure. It’s calculated as the earnings per share (before “extraordinary” or one-off items) divided by the total number of shares outstanding.

All these figures should be disclosed by the company. An ROE above 15 is very good, and one above 20 is excellent.

Cash flow statement

Cash flow is the lifeblood of a business. A business with no profit can live to fight another day; one with no cash flow cannot.

Companies can generate cash from their daily business operations, by selling large fixed assets or by borrowing or raising capital.

Obviously what you want is a company that’s generating a lot of cash through the course of its normal operations, and at a rate above what it needs just to operate.

That leaves it with enough cash to be able to distribute some to investors via dividends or share buybacks, or to reinvest in the business for growth.